Paying for CSR is Good Governance

More and more firms today are including incentives for corporate social responsibility (CSR) in their executive compensation contracts. But is this a worthwhile practice? Who benefits from it? Recent research shows a link between CSR activities and better social performance and the bottom line. But is paying for CSR beneficial for shareholder interests? Accounting and stock-price performance incentives are already common in executive compensation contracts to maximize shareholder value, which makes CSR incentives for financial performance potentially redundant. Some critics even argue that incentives for CSR are detrimental to firm profitability and growth. So, is there a place for CSR in effective executive compensation?

Actually, research says yes. Incentives for CSR are an effective tool for managerial compensation plans. They strengthen the executive compensation contract’s ability to serve shareholder interests even if financial performance incentives already exist. Executive compensation for CSR is common among firms with shareholder-friendly corporate governance. In fact, roughly 40 per cent of firms in the Standard & Poor’s 500 Index in 2013 included compensation for CSR outcomes as part of their incentive plans given to top managers. Compensation for CSR not only helps to serve shareholder interests, it is a sign of good corporate governance.

THE PROBLEM WITH PAYING ONLY FOR FINANCIAL PERFORMANCE

From a shareholder value perspective, paying only for financial performance might seem to make a lot of sense. If financial performance is all that matters to shareholders, why pay management for anything else? In practice, however, financial performance is not a perfect reflection of management’s abilities and the quality of their decisions. Financial results can be affected by many factors. For example, profits can decline despite a successful cost-cutting program if demand for that industry’s product or service deteriorates due to macroeconomic factors out of management’s control. And yet, a mediocre manager who has made poor decisions could see their company’s stock price rise due to an investment bubble in the industry. The reality is that financial performance metrics alone are a very imperfect measure of how managers are actually performing. Usually, they are not solely attributed to the management team’s actions.

Corporate boards that aim to maximize shareholder value should use executive compensation not to reward managers for luck, but to pay for their abilities and the quality of their decisions. However, this poses two significant challenges: measuring management’s ability and ruling out other independent factors. First, it is very difficult to measure and assess the ability and quality of managerial decisions, which prevents boards from paying strictly for management’s ability or decision-making. Second, performance outcomes may be used to measure management ability, but relying solely on financial performance reflects a mixture of ability, managerial decisions, luck, and other factors independent of management’s ability. Even powerful and well-intentioned corporate boards with their shareholders’ interests in mind encounter these problems of measurability and evaluation, so they resort to imperfect options.

So, in the absence of a perfect incentive structure for managers, what is the best option? The answer lies in using different performance metrics—both financial and non-financial. Although all performance measures are imperfect, each one is at least partly attributable to managers’ abilities and the quality of their decisions. By including incentives for multiple performance measures, each capturing at least some component of managerial ability and the quality of managerial decision-making, firms can provide incentives that more closely match compensation. For example, if product quality and customer satisfaction are critical for profitability, it may make sense to offer incentives to managers based on meeting clear performance targets along these dimensions, in addition to incentives based on purely financial performance metrics. Offering this multi-dimensional incentive structure reduces the problem of paying too much for luck, or other factors unrelated to the manager, as opposed to managerial ability and quality of decision-making. And, because compensation in this structure is more closely linked to a manager’s efforts, managers will have stronger incentives to perform well.

To illustrate the benefits of a multi-dimensional incentive structure, consider the adoption of non-financial performance incentives at a well-known global hotel chain (which we will call HotelCorp for our purposes). Prior to HotelCorp’s adoption of non-financial performance incentives, individual hotel managers were compensated with a base salary plus a bonus based on financial performance measures, including operating profit, revenues, and costs. Managers could earn up to 20 per cent of their base salary if they achieved their performance targets. Non-financial performance measures, such as customer satisfaction, were tracked but not linked to compensation. HotelCorp’s management then implemented a new incentive plan that included compensation linked to two customer satisfaction measures—the likelihood of customers returning and customer satisfaction—in addition to incentives linked to financial performance measures. After six months, both customer service measures improved, as well as total operating profits and revenues. The inclusion of non-financial performance incentives clearly improved the bottom line, even though financial performance incentives had already been in place.

THE CHALLENGE OF CREATING THE RIGHT MIX OF INCENTIVES

In 1991, the retailer Sears Holding Corporation instituted a profit-sharing incentive system in its auto centres to urge its mechanics to increase profitability. The new system was based on piece rates, where mechanics were paid a commission for every new component installed in customers’ cars. However, the firm eventually discovered that Sears employees, in response to the incentive plan, had been persuading customers to authorize unnecessary car-part replacements to increase their bonus compensation, which damaged the company’s reputation for excellent customer service. Sears ultimately abolished the incentive system, but by then the consequences had already impacted the business negatively and forced the company to pay regulatory fines to various state governments. By July of 1992, the U.S. Congress was holding hearings about fraud in the auto repair industry.

The Sears example is just one of several well-publicized cases in history where well-intentioned incentive structures have resulted in negative unintended consequences. All of the stories have the same lesson: people do what you pay them to do, and getting them to do exactly what you want is often not exactly what you are paying them to do. In the case of Sears’s auto mechanics, the original logic seemed compelling. If there is a performance measure that clearly leads to higher profits for the firm, then providing stronger incentives for that dimension of performance should also increase profits. Paying commissions for carpart replacements was intended to increase the motivation and productivity of employees, which it most certainly did. What was missing was the understanding that by simply increasing incentives on one dimension of performance without considering others, such as customer satisfaction and reputation, the mechanics at Sears did what their incentive structure told them to do. They focused on improving the performance metric that they were incentivized for, and ultimately sacrificed performance on other dimensions that were not included in the incentive plan.

Achieving intended good performance with incentive compensation is highly sensitive to choosing the right performance measures. Therefore, using monetary incentives to motivate behaviour is often far from a straightforward exercise. This poses yet another challenge for corporate boards that want to provide the right incentives to maximize shareholder value. It’s not enough to include multiple performance measures; it is important to include all of the relevant performance measures. If a significant performance measure is left out, management may focus on only some important metrics and neglect others that are critical to increasing shareholder value.

WHY PAYING FOR CSR CAN SERVE SHAREHOLDER INTERESTS

If all relevant performance measures must be incentivized, should CSR be one of the performance metrics? The answer to this question depends on the role of CSR in the firm’s operations. Does the company consider CSR as important as other types of performance metrics such as customer satisfaction and operational efficiency measures, which may already be compensation incentives? For example, Freeport-McMoRan, one of the world’s largest copper- and gold-mining firms, offers top managers 15 per cent of their annual incentives for meeting sufficient worker safety standards. Preventing worker injuries is not only socially responsible, it positively affects the bottom line by avoiding operational disruptions, reputational damage, and potential regulatory fines. In 2014, the firm recorded its lowest rate of health and safety incidents in the company’s history.

But from a shareholder value perspective, CSR is only an appropriate performance measure for an executive compensation plan if the specific CSR measure used is relevant to the firm’s financial performance, which it is for Freeport-McMoRan and worker safety. The relevance of CSR to the firm’s profits determines if it is a useful measure of management’s ability and quality of decision-making, which relates to financial performance. For example, if the firm’s operations have social impacts with potential financial performance consequences, then CSR is likely to be a relevant performance metric for executive compensation.

CSR can be a useful performance measure to improve the effectiveness of managerial incentives. It is also worth considering the risks of omitting social performance from a compensation contract. In other words, if CSR is relevant to a firm’s financial performance, what are the consequences of excluding it from an executive compensation plan?

As discussed earlier, managers are very likely to do exactly what firms pay them to do, even if it is not necessarily what the firm would like them to do. If a firm provides incentives for other performance metrics but omits social performance, then managers are very likely to give greater attention to improving the performance metrics they are compensated for. This can occur even if social performance impacts financial performance, when incentives for financial performance may already be in place. This is because the relationship between a manager’s ability and the firm’s financial performance is imperfect, and the same reason why simply paying for financial performance is insufficient. However, if other non-financial performance measures are more directly a function of a manager’s abilities and decisions—such as operating-efficiency metrics—managers may give more attention to improving these metrics in order to achieve their compensation targets. Therefore, they may devote less time and effort to social performance, ultimately leading to the detriment of the firm.

CORPORATE GOVERNANCE AND EXECUTIVE COMPENSATION FOR CSR

Ivey Business School research on corporate governance and executive compensation for CSR examined whether incentives for CSR in executive compensation contracts were systematically related to more (or less) shareholder-friendly corporate governance. To confirm our hypothesis, firms with more shareholder-friendly corporate governance should be more likely to provide incentives for CSR. This would imply that CSR incentives make executive compensation contracts more effective in increasing shareholder value. Empirical tests were conducted on hand-collected compensation contract data from Securities and Exchange Commission (SEC) filings for the top five highest-paid executives of firms in the Standard and Poor’s 500 Index, linked to corporate governance measures commonly used in the academic literature in finance.

Firms with executive compensation plans linked to non-financial measures of social performance, ranging from environmental sustainability to workplace diversity, were identified as providing incentives for CSR. We found consistent evidence that firms with more shareholder-friendly corporate governance were more likely to observe executive compensation contracts with incentives linked to CSR outcomes.

For example, a one standard deviation increase in the percentage of the board of directors hired before a CEO’s arrival increased the odds of compensation for CSR by 13 per cent. The incremental addition of a large institutional “block” shareholder (an institution owning more than 5 per cent of a firm’s outstanding shares) increased the odds of observing CSR incentives by 8 per cent. Therefore, board members hired before the CEO’s arrival were less likely to be vulnerable to influence by the CEO, and large block shareholders wielded considerable influence over a firm’s management because of their collective voting power.

Our study also found that when managers had greater individual power within the firm and governance was less shareholder-friendly, firms were less likely to have executive compensation contracts tied to CSR outcomes. A one standard deviation increase in the shares outstanding owned by an executive lowered the odds of observing incentives linked to CSR by 8 per cent. If the executive was also a member of the board of directors, the odds dropped by 19 per cent. Therefore, if managers own more shares or sit on the board, or both, they gain greater individual power and discretion to act in their own self-interest, which makes the firm’s corporate governance less effective in serving the shareholders’ interests.

HOW CORPORATE BOARDS CAN USE CSR INCENTIVES TO MAXIMIZE SHAREHOLDER VALUE

Creating the right incentives for management teams is no easy task for corporate boards. Faced with a world of imperfect performance measures, compensation incentives must rely on a complementary set of financial and non-financial performance measures that best approximates managerial ability and the quality of decision-making.

So, what steps can a firm take to create the right mix of incentives? What conditions determine if CSR should be included as a component of executive compensation plans? Both of these issues are discussed below.

Identifying the types of CSR that are important for the firm’s strategy and operations

CSR makes managerial incentives more effective if social responsibility is relevant in determining the financial performance of the firm. However, not all types of social performance are equally important for all firms. For some companies, like Freeport-McMoRan, worker safety is a critical aspect of the firm’s operations. In other cases, environmental sustainability, employee culture, or other types of social performance may play a more prominent role. Identifying the types of social responsibility that are important for the firm’s bottom line is the first step in determining whether compensation for CSR might improve executive compensation incentives. However, the mechanism through which CSR impacts financial performance should be clear, not speculative.

Choosing clear metrics to define good social performance

Once the relevant types of social responsibility are identified, each type must be measured with clear metrics to define better and worse performance. Chosen metrics should capture the true social performance as closely as possible. Indirect measures that only loosely relate to the type of social performance identified should be avoided. For example, if workplace safety is important, then the number of safety incidents occurring annually as a percentage of the firm’s total relevant workforce clearly captures overall workplace safety. For environmental concerns, total annual toxic emissions may serve as a reasonable proxy for the firm’s environmental impact. Good measures that capture social performance will increase and decrease meaningfully when the true underlying social performance changes.

Chosen performance measures must also be objective. If accounting financial performance measures can be manipulated, subjective measures of social performance are even more vulnerable to manipulation and optimistic interpretation.

Finally, corporate boards should avoid adjusting the incentive compensation system to accommodate poor social performance. The board must maintain the credibility of the compensation incentives that have been set in place.

Seeking continuous improvement along the chosen social performance dimensions

When managers are given incentives for financial performance, they are expected to continuously increase financial performance over the long run. The same should be expected of the chosen CSR measures.

For example, if the relevant measure of CSR is toxic emissions, then incentives should be set in place to ensure that toxic emissions are reduced continuously each year, with respect to the firm’s growth and other exogenous factors. Incentives for CSR should discourage poor and stagnant social performance along the relevant dimensions being measured. They should encourage managers to seek continuous improvement.

A number of scholars and social activists have blamed poor social performance by firms on too narrow a focus on shareholder interests, and have called instead for a broader stakeholder-oriented view. By framing the shareholder and stakeholder viewpoints as having systematic and substantial conflicts of interest that compete in a zero-sum game, corporate boards and managers are made to believe that they have little choice but to make difficult tradeoffs between serving their shareholders and investing in social responsibility. In this view of the world, managers can only lose—either in profits or in their social performance contribution to society.

However, for corporate boards trying to maximize the effectiveness of their executive compensation plans, this view may be unnecessarily strict. If the right performance metrics are chosen, CSR can be an important part of a shareholder value-maximizing executive compensation plan for many firms, where social performance can impact financial performance.

Corporate boards that weigh their responsibilities to society and their fiduciary duty to their shareholders can find a mutual benefit by implementing CSR incentives effectively. Stakeholders who wish to see improved social performance, and shareholders who are concerned about financial return on investment, can both equally reach their goals.